Minutes of the Monetary Policy Meeting of the Reserve Bank Board
Sydney – 6 July 2010
Glenn Stevens (Chairman and Governor), Ric Battellino (Deputy Governor), Ken Henry AC (Secretary to the Treasury), John Akehurst, Roger Corbett AO, Graham Kraehe AO, Warwick McKibbin
Members granted leave of absence to Jillian Broadbent AO and Donald McGauchie AO in terms of section 18A of the Reserve Bank Act 1959.
Guy Debelle (Assistant Governor, Financial Markets), Philip Lowe (Assistant Governor, Economic), Tony Richards (Head, Economic Analysis Department), Anthony Dickman (Acting Secretary)
Members were briefed on ongoing tensions in European financial markets. Concerns over the fiscal position of some European countries had persisted since the June meeting. Moody's had downgraded Greece's debt in mid June, so that Greece was no longer rated investment grade by any of the three major rating agencies. Moody's had also placed Spain's AAA rating on review for possible downgrade. There had been some adverse sentiment over the outlook in Hungary following statements about the fiscal situation by the new government.
Amid heightened concern over the health of the European banking system, European authorities announced that results of a stress test of the largest European banks would be publicly released in the second half of July. Members observed that, in order to settle markets, it was critical that the stress tests be regarded as credible and that plans be in place to deal with any capital shortfall identified by the stress tests.
For the major economies sovereign-level yields had fallen, with US 10-year yields falling below 3 per cent and German yields declining back to historic lows. Australian Government yields had also fallen over the month to 5 per cent. Although there was little market trading, indicative pricing suggested a widening in spreads for Greece and a number of other euro area economies. The European Central Bank (ECB) had purchased €59 billion in euro area sovereign debt securities since its buying operations had started a few weeks earlier.
Members discussed recent developments in the market operations of the ECB. They noted that the maturing of the large one-year liquidity operation had occurred relatively smoothly on 1 July and been replaced by a smaller three-month injection. Nonetheless, there had been some increase in money market spreads, although these remained far lower than over mid 2007 to mid 2009. There had, however, been some tiering in spreads paid by different banks.
In Australia, the money market had continued to function well. There had been some upward drift in the Australian bank bills-to-OIS spread. Members noted that, as in previous years, the Bank had temporarily supplied extra liquidity at the end of the financial year.
The tensions in European financial markets had seen a further pushing back in the expectations of when central banks in the three largest advanced economies would begin tightening policy. However, about half a dozen other countries had announced monetary tightening during the month. These included three – Canada, New Zealand and Sweden – that took their initial steps in this cycle. Domestically, members noted there was no expectation of any change in monetary policy at the current meeting.
Globally, corporate bond issuance remained at low levels in June, although there had been some pick-up relative to May, mostly reflecting issuance of covered bonds in the euro area. Issuance by Australian entities had also picked up from the extremely low levels of May. Some of the large domestic banks had issued bonds. Members noted that the spreads on these issues were moderately higher than earlier in the year. There had been further issues in the local securitisation market, including the first US-dollar RMBS issue since the onset of the crisis in 2007.
Members discussed trends in the funding of Australian banks. Over the past couple of years, there had been a reduction in the share of funding coming from securitisation and short-term debt, and an increase in the share of domestic deposits and long-term debt. While there had recently been a modest increase in some funding costs, some lending rates (particularly for businesses) had risen in line with market rates, such that there had been little change in net interest margins.
Global equity markets had recovered somewhat in the first part of June, but turned down sharply again later in the month. The Chinese equity market had continued to record significant declines.
In foreign exchange markets, the major development had been the announcement by the People's Bank of China (PBC) of a change to the exchange rate regime. The PBC had reverted to the arrangement in place over 2005 to mid 2008, whereby the value of the renminbi would be adjusted in small increments on a daily basis. The PBC had stated that it viewed the exchange rate as close to fair value, and so far the daily changes had been small and in both directions, for a net appreciation of around 1 per cent. Over the past year, however, the renminbi had appreciated considerably in trade-weighted terms, reflecting its rise against the weakening euro. The Australian dollar had traded in a wide range but the trade-weighted index was little changed over the month.
International Economic Conditions
The discussion then turned to international economic developments. Members noted that the global economy had continued to grow in the June quarter, although uncertainty about the future strength of the recovery had risen and downside risks were apparent, largely reflecting ongoing concerns about the fiscal situation in Europe and the health of the European banking system. In contrast, economies in Asia remained robust, although there were signs that growth in the region was moderating to a more sustainable pace after the strong V-shaped recovery of the previous year.
In Europe, many governments had recently announced discretionary tightening of fiscal policy. Spain, Italy and Portugal announced fiscal tightening amounting to at least 2 per cent of GDP over the coming year, while Greece had announced tightening measures equivalent to 8 per cent of GDP. Some of the larger economies had also announced some tightening of fiscal policy, although the cuts were smaller and would be implemented more gradually.
The timely survey data on euro area confidence and current business conditions had shown surprising resilience for the period since early May, despite the financial market turbulence. More generally, the economic data for a number of countries, most notably Germany, was more positive than had been the case a few months earlier, and it was likely that euro area GDP would record a solid rise in the June quarter after little growth over the previous half year. Members noted that the German labour market had held up very well over the past two years.
In China, retail sales, fixed asset investment, exports and credit had all grown strongly in May. On the other hand, growth in industrial production had moderated over the past few months. Members observed that some slowing in industrial production had been inevitable from the growth of over 20 per cent seen earlier this year. Conditions in the property market had also cooled, particularly in the major cities. Growth in higher-end residential construction was likely to slow over coming quarters, with the authorities encouraging growth in construction of housing for lower-income residents.
Wage growth in China had recently picked up noticeably. This was not surprising given the strong economic expansion over the past year and the freezes in provincial minimum wages in 2009. From a structural perspective, this growth could be regarded as a positive development if it were part of the shift in national income towards the household sector that is required over the longer run. In the short run, it could add to rising inflation pressures, although members noted that the authorities' new approach to the exchange rate had the potential to assist in macroeconomic management over the period ahead.
Elsewhere in Asia, there were also early signs that growth was returning to a more sustainable pace after the very strong bounce-back from the contraction in late 2008 and early 2009. Export volumes had continued to grow solidly and labour demand had been strong, although industrial production had been broadly unchanged in some economies over April and May. The Japanese economy was continuing to recover, although there remained considerable excess capacity.
In the United States, economic recovery was continuing at a moderate pace. This was most apparent in the business sector, especially in manufacturing. Indicators of business equipment investment were improving, business surveys were positive and industrial production had grown solidly. However, labour market conditions remained soft and the payrolls data (excluding census jobs) for May and June had been disappointing. Unlike in Europe, no new steps had yet been taken to tighten fiscal policy, although there would be some unwinding of temporary measures through this year.
The large output gaps in the United States and the euro area had been reflected in an ongoing decline in inflation, with core inflation running at annualised rates of ½–¾ per cent over the past half-year. Inflation was significantly higher in the United Kingdom, partly reflecting the increase in the VAT rate and the depreciation of the pound sterling. Inflation in China had picked up after the deflation seen in early 2009, although it appeared to have stabilised at an annualised rate of around 3 per cent over recent months.
Domestic Economic Conditions
The recent flow of data suggested that the domestic economy continued to expand at a solid pace, with public-sector spending providing support to activity. The national accounts for the March quarter had been released the day after the June meeting and showed an increase in GDP of 0.5 per cent in the quarter and 2.7 per cent over the year. Looking forward, the staff expected growth in private demand to pick up as investment strengthened, supported by high commodity prices.
Consumer sentiment remained modestly above its long-run average, although it had fallen recently. However, sales of motor vehicles to households had been strong in recent months and retail spending had recorded increases in March, April and May after showing little growth over the previous nine months. Liaison with retailers in late June suggested a slightly more positive picture than a few months ago, although many retailers reported that conditions remained subdued and that significant discounting had been required to drive sales.
Business surveys had also indicated some easing in confidence over recent months, although trading conditions remained a little above average levels. Recently, some measures of firms' investment intentions had increased quite strongly, and capital goods imports increased in May, which would be consistent with the staff forecast of a gradual pick-up in private-sector investment. In addition, the amount of work yet to be done in mining was very high, particularly for the LNG sector. Business credit had recorded a modest increase in May after declining for most of the preceding year and a half. Notwithstanding this, private non-residential approvals remained weak; if this persisted it suggested a tightening in some commercial property markets could emerge in the medium term.
The slowing in growth in Chinese steel production had been reflected in falls in iron ore and steel prices. Spot prices for iron ore were now below the estimated contract price for the September quarter. Spot prices for coking coal had also eased. Nevertheless, these prices remained very high from a longer-term perspective, and the terms of trade were approaching the peak level seen in 2008.
There were some signs that conditions in the established housing market had eased. In particular, auction clearance rates in Sydney and Melbourne had declined from their earlier elevated levels, with the clearance rate in Melbourne in June back around average levels. Price data to May were mixed but provided some tentative evidence of a deceleration in growth relative to earlier in the year. Members noted that price growth had been very strong in Melbourne. Housing credit growth in May had remained at around the average pace of the preceding year.
In the labour market, hiring had remained strong with employment having risen again in May, to be 2½ per cent higher over the year. Continuing the pattern of recent months, the increase was entirely driven by full-time jobs. Business surveys and data on job advertisements had been generally firm, suggesting further solid gains in employment in coming months. The unemployment rate had fallen to 5.2 per cent in May, which members noted was a significantly better outcome than had been expected a year earlier.
The federal minimum wage decision was for an increase of 4.8 per cent from 1 July, following the wage freeze last year. According to staff estimates, this implied an average increase for all workers on awards of around 3½ per cent, and was expected to have only a relatively small effect on overall wage growth.
Consumer price inflation data for the June quarter would be published on 28 July, and the staff expected them to show the underlying rate of inflation continuing to moderate in year-ended terms, to be below 3 per cent for the first time in three years. CPI inflation was, however, expected to rise to a little above 3 per cent, partly due to the effects of higher taxes on tobacco. Measures of inflation expectations had eased a little over the past month.
Considerations for Monetary Policy
The global economy had continued to expand at around trend pace in recent months, although the pattern of growth was uneven among regions and developments in financial markets over the past month had highlighted some important risks. There had been further focus on the European fiscal situation and banking sector problems. While the measures being taken there should help the prospects for sustainable growth over the longer term, prospects for European growth going into 2011 were weaker. The US economy had shown moderate growth in the first half of 2010, but members noted that recent labour market outcomes had been disappointing.
Members saw some moderation in Asian growth as desirable, given concerns about possible overheating in those economies, but there was likely to be some uncertainty in the near term about the extent of the slowing. For Australia, a critical medium-term question was the extent to which economies in Asia could continue to grow strongly in the face of what could be an extended period of subdued conditions in the major North Atlantic economies. Overall, members considered that the most likely outcome was for growth in Australia's major trading partners to be around trend over the next couple of years.
The domestic economy had been growing at a solid rate over the past year, including a sizeable contribution from fiscal spending. The economy was now entering a period in which private demand was expected to strengthen due to a pick-up in business investment flowing from the high level of the terms of trade. This was expected to offset the scaling back in public demand that would be taking place. There were tentative signs that this ‘hand over’ from public to private demand may be starting to occur, though this would warrant careful monitoring.
As at the June meeting, members judged that the decisions at earlier meetings to increase the cash rate, which had resulted in interest rates paid by borrowers returning to around average levels, afforded flexibility to maintain steady settings in the face of increased international uncertainty.
Members noted that the coming month would see important announcements about the health of the European banking sector, which had the potential to have a significant impact on financial markets and global confidence. There would also be an updated reading on domestic prices. This was expected to show further moderation in the year-ended underlying rate, although underlying inflation was likely to remain in the top half of the target range over the period ahead. Headline inflation was expected to rise, owing to the effects of some tax increases, with the year-ended increase in the CPI rising above 3 per cent. The important question for the Board at its next meeting would be whether the new information materially changed the medium-term outlook for inflation.
Pending this information, the Board judged it appropriate to hold the cash rate unchanged.
The Board decided to keep the cash rate unchanged at 4.5 per cent.